[Editor's Note: This is the latest installment in Money Morning's "Quarterly Outlook" series which has covered such topics as the housing market, silver, and technology. For more information on M&A activity, click here to read a related story in today's issue about how to spot potential deal-making companies.]

Your email address will not be published. Required fields are marked *

Comment

Some HTML is OK

Sign me up for the Money Morning newsletter

Name *

Email *

Website

− three = 3

Mergers and acquisitions, or M&A activity, so far in 2011 has been a driving force in the stock market's positive performance.

In fact, global M&A activity in the first quarter topped $799.8 billion, the most since 2007's pre-crash frenzy, according to a recent report in Forbes magazine.

MergerInvesting.com, which tracks the M&A market, says 130 deals have either already been closed in 2011 or are currently pending. And, while the total number of global deals is down slightly from the same period in 2010, the actual value of the deals is up more than 55% (with deals involving U.S. companies accounting for 49.6% of that total – a 117% jump from 2010).

Looking forward, most M&A analysts now predict more than $3 trillion in takeover activity for all of 2011.

Striking While the Iron is Hot

As a rule, takeover attempts are driven by economics. The acquiring company may have a lot of cash on hand and buying another firm offers a greater potential return than any other investment the acquirer can make. A recent report estimated that non-financial companies in just the United States are currently sitting on $1.93 trillion in cash – the highest total since 1959. And with bank deposits and bond interest rates essentially yielding nothing, acquisitions make sense in terms of boosting corporate returns.

Cash-rich companies typically look to buy firms whose activities fit with their own line of business; offer an entry point into a new and compatible market segment; that are profitable; that also have a large amount of cash on hand; and that are undervalued.

Attractive valuations are another key reason 2011 has been a good year for M&A activity. The Standard & Poor's 500 Index is currently priced at an average of just 12-times free cash flow, whereas the average takeover in 2010 was done at 20-times free cash flow. Numbers for 2011 haven't yet been tabulated, but buyouts in 2010 were accomplished at an average price of $1.24 per dollar of the acquired company's sales – which is a pretty cheap way for the buyers to add a dollar in revenue to their balance sheets.

Increasing desire among cash-laden Asian companies to gain a firmer foothold in the U.S. market also is helping to fuel takeovers. Last year, Asian companies executed more than 8,700 buyouts worldwide (about 70% of them for cash), with about 425 involving American companies.

Some of the Asian acquisitions illustrate another key point about takeovers – not all of them are strictly about economics. In many cases, a company will engineer an acquisition to improve its cultural image, expand its strategic reach (even if it's not totally profitable) or achieve new political influence.

Finally, the egos of top corporate officers often can play a major role in driving high-profile takeovers. That is, acquisitions can add to the perception of power or business acumen of the executives who put together the deal.

Mergers Vs. Acquisitions

Although they're generally mentioned in the same breath, there's actually a significant difference between mergers and acquisitions for shareholders. Acquisitions usually offer the potential for much larger gains for shareholders than do mergers.

In an acquisition, one company is acquired by the other – using either cash, stock or a combination of the two – and the company being bought or taken over ceases to exist, as does its stock. The stock of the acquiring company continues to trade, representing the new value of the combined companies.

In a merger, two companies combine into one and both companies cease to exist. The rewards to the shareholders – at least in immediate terms of stock prices – are generally lower than in acquisitions. Sometimes, the stock of one of the merger parties is adjusted to reflect the deal and continues to trade for the combined companies; in others, the stocks of both companies cease to exist, with new shares being issued for the merged entity.

Though there are no guarantees, and the market's response to buyout announcements can vary widely, deals generally mean hefty gains for investors in the target companies. Here are just a few examples from some of the deals announced so far in 2011:

Cephalon Inc. (Nasdaq: CEPH) stock rose from $57.57 when Valeant Pharmaceutical Int.'s (NYSE: VRX) offer was made on March 28 to $75.44 on March 30 – a gain of 31% in two days.

National Semiconductor Corp. (NYSE: NSM) went from $14.07 on April 4 to $24.06 on April 5 – a one-day gain of 71% – following an offer from Texas Instruments Inc.'s (NYSE: TXI) offer.

And Lubrizol Corp. (NYSE: LZ) climbed from $105.44 on March 11 to $133.77 on March 15 – a gain of 26.8% – after Berkshire Hathaway Inc. (NYSE: BRK.A, BRK.B) made an offer for the company.

Of course, not all takeover bids spark moves of those magnitudes. Progress Energy Inc. (NYSE: PGN), for example, rose to just $47.20 a share, from $44.20, in the two weeks following Duke Energy Corp.'s (NYSE: DUKE) bid.

Still, nearly all M&A deals generate some immediate gain for shareholders – enough to make the search for takeover situations a worthwhile pursuit for savvy investors with a little extra cash on their hands.

Let's Make a Deal

There are a number of companies with strong potential for getting scooped up by hungry buyers, and interested investors can scan the market for these likely targets.

One way to spot potential takeover targets is to look at industries or sectors where consolidation is already occurring and target the likely losers should takeover activity continue. That's what's currently happening in the mobile communications sector, and it's the source of one good current buyout candidate:

Millicom International Cellular SA (Nasdaq: MICC), recent price $97.70 – Millicom is a global company, based in Luxembourg. It has landline, cable and broadband operations in five countries in Latin America, and mobile operations in 14 developing markets around the world. Earnings and revenue have grown in four of the past five years, hitting a whopping $15.26 a share in 2010. The company also finished 2010 with $1.03 billion in cash and reported free cash flow of $454.6 million. And, if it doesn't get bought right away, it also pays a dividend of $2.38, good for a yield of 2.47%.

Another possibility with ties to the communications sector, as well as a key product niche is:

ARM Holdings (Nasdaq: ARMH), recent price $29.22 – ARM is a leader in the production of processors for mobile phones, ARMH could be a potential target for any of its customers, including Apple Inc. (Nasdaq: AAPL) (both the iPad and iPhone use ARM chips). The company earned 32 cents a share in 2010, has $456.2 million in cash in the bank and a levered free cash flow of $169.94 million. The stock also pays a 15-cent dividend.

Petrohawk Energy Corp. (NYSE: HK), recent price $25.14 – A leading U.S. natural gas producer. Petrohawk had earnings of 63 cents a share in 2010 on revenue of $1.6 billion. Its Enterprise Value to EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization) ratio is an acceptable 9.89, meaning the company generates good profits relative to its size. Though it's a bit short on cash and free cash flow, its infrastructure and reserves make it an attractive target, with Fitz-Gerald estimating a potential buyout price of $30 a share or more.

Although it's unlikely you'll get a 40% or 50% pop in a single day, another way to profit from the M&A market on a longer-term basis is to invest in the companies that help engineer the takeovers. Though not at the top of the deal-making list, two possibilities we like in this category are:

Evercore Partners Inc. (NYSE: EVR), recent price $33.47 – This firm – which specializes in M&A, corporate restructuring after bankruptcy filings, and asset management – is only mid-sized but it has some heavyweight clients. It advised AT&T (NYSE: T) on its deal to acquire T-Mobile, and also counseled optionsXpress Holdings Inc. (Nasdaq: OXPS) on its recent $1 billion sale to The Charles Schwab Corp. (NYSE: SCHW). The stock pays a 72-cent dividend, good for a yield of 2.14%.

Piper Jaffray Companies (NYSE: PJC), recent price $37.77 – PJC gets more than 50% of its revenue from investment banking, with a focus on M&A counseling and financing, and also acts as a rep for several major private equity groups. The company increased revenues and earnings in each of the last three quarters, reporting $1.53 per share profit in 2010.

The M&A markets get a lot of press, but they're also ignored by most individual investors, who feel it's too difficult for "outsiders" to get in quick enough to make a major profit. However, if you start thinking like the potential buyers and doing a little extra analysis, you should be able find enough likely takeover targets to acquire some substantial profits of your own.

Money Morning gives you access to a team of ten market experts with more than 250 years of combined investing experience – for free. Our experts – who have appeared on FOXBusiness, CNBC, NPR, and BloombergTV – deliver daily investing tips and stock picks, provide analysis with actions to take, and answer your biggest market questions. Our goal is to help our millions of e-newsletter subscribers and Moneymorning.com visitors become smarter, more confident investors.